Inflation expectations in EM could be seriously disrupted if wheat and maize prices keep rising, just as benign food price developments in Q2 played an important role in pushing inflation expectations down. Global food inflation fell from 21% in Q1 to 7.2% in June, but is now on the rise again: the FAO’s global food index for July was published last week, and shows food inflation rising to 12.5%.

The impact of higher food prices on CPI varies widely across countries, but broadly speaking it appears that Asia has the highest sensitivity to higher food prices, and Latin America the lowest.

It is difficult to generalise about how higher food prices will affect policy interest rates, particularly since the impact of more expensive cereals can be partially offset by stronger exchange rates, both for wheat-importing and for wheat-exporting countries.

On balance, though, we think that the risk of accelerated rate hikes should be taken seriously, given the sensitivity of inflation surprises to food prices in the past few months. And since China is one of the countries whose CPI seems to be particularly sensitive to rising food prices, the global consequences might become more visible. The market would probably not welcome a Chinese dilemma in which policymakers had to struggle against sharply higher inflationary pressure as well as a real economy slowdown.

An additional risk arises from the fact that foreign ownership of EM domestic fixed income markets has risen in the past few months. If food prices produce nasty inflation surprises in the next few months, the risk is that investors lighten their positions in EM fixed income markets, producing a small negative spiral of higher inflation, capital outflow and weaker exchange rates.